Don’t Jump Ship When the Markets Get Rough

Last time I discussed ways you can hang in there during tough markets. Let’s take a look at the consequences if you throw in the towel too early.

Over the summer, we saw bad news followed by more bad news in markets around the world. The broad US market lost about -15% and international stocks dropped about -20% from July-September.

While the current downturn is worrisome, let’s look at what investors experienced during previous market downturns. Table 1 shows various US market downturns from 1960-2010 and the subsequent 12 month returns that immediately followed the downturn. There are several points I’d like to highlight:

There have been nine downturns that resulted in losses of more than 20%. The average downturn resulted in a loss of -35%. US markets already dropped -20% from this year’s high. So from this perspective the downturn this year, while painful, is not the worst we’ve experienced.

That brings me to some bad news: we may not necessarily have hit the bottom yet and might still have a while to go since the current losses are less than what we’ve experienced in the past. But as always, predictions are just guesses about the future. This time it could truly be different–both in terms of having fewer losses, or potentially having more losses than historical averages.

The average downturn lasted about 13 months before the recovery. Right now we’ve “only” experienced 3 months of losses. So not only has the depth of the current losses been less than average, the time period of this year’s downturn is far away from the average time period of previous downturns. In other words in previous downturns you had to hang in there far longer than what you’ve done this year.

Not every downturn resulted in a recovery. For example, the losses from 2000-2001 was followed by another 12 months of losses.

While none of that is encouraging, fleeing the market during the downturn can have some disastrous consequences for your portfolio:

You can see that the subsequent recoveries were huge, with average gains of about 39% over a 12 month period.

Not only were the gains bigger in percentage terms, but they happened in a shorter amount of time than the downturns.

In other words downturns tend to last longer than the rapid recoveries that follow.

The swift upturns can leave you far behind if you bailed out of the market during the downturn. Imagine a scenario where you sold stocks in the downturn and also missed the upturn. You just experienced the worst combination possible.

While the current confluence of events has not happened before, realize that the current downturn is of a size that we’ve experienced before. And since no one can consistently time the market, the consequences of fleeing during these times can potentially leave you worse off than you would be if you stayed the course.

While the stats show that markets usually recover, what should you actually do? I think that depends on your particular situation, but here are some general guidelines, broken down by your age.

Ages 30-45
If you just finished residency or have been practicing medicine for 10 years or less, you’ve just been handed a fantastic opportunity. There is generally an inverse relationship between today’s prices and future returns. Lower prices today usually means that you can expect higher future returns. The problem is that you aren’t guaranteed higher future returns, and you don’t know when they’re going to happen. That’s part of the risk of investing. So you have to be incredibly patient with this and continue saving and buying more stocks at these prices.

Taking it one step further, you should hope that prices fall even more for the next several years so you buy at even lower prices. Realize that you’ll be doing this when there’s no good news and you feel like the world is coming to an end. But that’s how you generate the returns you want to get to fund your retirement. So keep socking it away.

Ages 45-55
In the mid part of your career you’re still saving and investing more in the market, but one thing you have to keep in mind is the possibility that prices won’t recover for a long period of time–say 10 years or more. Many EPs I speak to say they can’t possibly work full time in the ED when they’re 60 years old. So if you’re 45 years old and you’re thinking about retiring at age 55 from EM, you should be prepared to work longer or save more now to make up for losses.

Ages 55+
Just when you get a glimpse of the finish line, it moves further away. If you’re just about to retire or entered retirement this year, you should be very worried if you don’t have a plan. Remember the market doesn’t recover swiftly every time–like in 2001-2002. Or consider 1965-1981, when for 17 years US stocks underperformed bonds. That means you need to make some critical adjustments:

What monthly expenses are you going to cut?

Will you work part time to generate income to make up for portfolio losses?

Should you change your asset allocation and reduce risk in your portfolio?

Ultimately you need to figure out whether you’ll outlive your money.

Setu Mazumdar, MD practices EM and he is the president of Lotus Wealth Solutions in Atlanta, GA. www.lotuswealthsolutions.com

Comments

Always a good reminder to stay the course with your investments. It's so easy for an investor to forget that the long-term is just that. In ten years no one is going to be worrying about Google's 2011 earnings or Greece's default.